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July 5, 2013

DC Plans vs. DB Plans: Who Won the EBRI Stress Test?

The results depend on interest rates and annuity prices

The Employee Benefit Research Institute conducted in June a comparative analysis of the likely benefits to participants in 401(k) plans, final-average defined benefit plans and cash balance plans.

The analysis found the 401(k) plans had the advantage if historical rates of return and annuity purchase prices remain the same. However, a variety of stress tests changed the outcome for each of the plans.

EBRI excluded 401(k) plans with automatic enrollment on the assumption that despite the increased prevalence of automatic enrollment, “there are still a number of assumptions with respect to opt-out behavior” that need additional data before they can be included in the analysis.

When the plans were subjected to different stresses, including decreasing the rate of return and increasing the annuity purchase price to the current bond rate, lower-paid employees would fare better with a DB plan than with a 401(k), but still had the advantage over the cash balance plan.

EBRI found that the competitive advantages of a 401(k) plan increased the longer a participant was in the plan. Workers with one to 10 years of simulated future eligibility in a plan had a median advantage of one percentage point over the DB plan, 10 with 11 to 20 years of future participation and 21 points at 21 to 30 years. Those with 31 to 40 participation years ahead of them had a 44-point advantage.

For the most part, the first three eligibility groups broke even between the 401(k) plan and the DB plan. However, between 60% and 70% of workers in the lowest income quartile with 31 to 40 years of participation ahead of them would get a larger annuity when they retired at 65 with a 401(k) plan than if they had been covered by a DB plan.

In the highest income quartile, about 60% of workers with one to 10 years of future participation could get higher benefits with the 401(k) plan. For those with 31 to 40 years, between 80% and 90% could get more benefits from the 401(k).

When EBRI increased the annuity price in line with what a 65-year-old woman would pay, as opposed to the lower rate a man with a shorter life expectancy would pay, EBRI found that keeping all other variable the same would reduce the advantage of a 401(k) plan by three percentage points.

By reducing the rate of return by 200 basis points from the historical rate for all asset classes, EBRI found that in both the 401(k) plan and the DB plan, workers with more future participation years were affected most. In the lowest income quartile, the advantage of a 401(k) plan for those with 31 to 40 years of future participation fell 19 points compared with the DB plan and 21 points compared with the cash balance plan. In the highest income quartile, the advantage fell 30 points for the DB plan and 29 points for the cash balance plan.

“Even with these dramatic shifts in return assumptions, however, all eligibility classifications for employees in the third and fourth income quartiles still have a positive median advantage for VE [voluntary enrollment] 401(k) plans versus the stylized, final-average DB plans,” according to the report.

EBRI found that in plans affected by both a decrease in the rate of return and an increase in the annuity purchase price, the advantage of a 401(k) plan to the youngest workers in the lowest income quartile falls 28 points. For those in the highest income quartile, the difference is 42 percentage points. “Overall, under that set of assumptions, the median relative advantage of VE 401(k) plans over the stylized, final-average DB plan disappears for all but the highest-income quartile with 31‒40 years of eligibility.”